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The Spanish Donkey

The Spanish Donkey, a feared torture device from the middle ages, consisted of a wedge on which the victim was seated with weights tied to his or her legs so that with enough weight, the wedge could even slice though the victim’s entire body. Arguably, the Spanish economy now sits atop such a wedge weighed down by deep austerity measures and unprecedented unemployment on the one side and by large unknown losses in the banking system brought about by a real-estate bubble that has burst on the other.

What is worse is that these two aspects weighing the economy down reinforce each other in a manner that is clearly not understood that well by EU policy makers. The Spanish economy today is at a point where every bit of austerity, measured in percentage points of GDP, leads to a reduction in demand that is even larger. So a 1% cut in government spending is likely to lead to a fall in GDP that is larger than 1%. This is because the uncertainty over the future of Spain and the fact that tomorrow, at this point, looks worse than today mean that neither consumers nor businesses are spending so a reduction in government spending translates directly into lost demand in the economy. What’s worse is that the expectation of falling GDP that accompanies such austerity means that both consumers and firms will make further cutbacks to their consumption and investment plans.

Even worse, such falls in GDP are pushing the unemployment rate ever higher, above and beyond the almost incredible sounding 25% level. The unemployment rate and expectations of growth are in turn two parameters that have a very large impact on the state of the housing market. The facts that citizens are personally liable for mortgages (unlike say in the United States) and that personal bankruptcy laws are very harsh mean that people have continued to service mortgages even under very onerous circumstances. However, rising unemployment and the expectation that things will continue to get worse can lead to the bottom falling out of this market. There is evidence of an ‘ever greening’ of loans and of forbearance on the side of the banks so the real economic size of the problem is already worse than what has been acknowledged thus far and deteriorating by the day.

Till date the vast majority of losses that have been recognized in the Spanish banking system have had to do with loans to real estate developers and commercial real estate. These will continue to deteriorate given worsening economic prospects. But few loan loss provisions have been set aside against residential mortgages and business lending. As unemployment rises and the GDP shrinks without any near-term prospects of recovery on the horizon, losses from these will multiply.

Meanwhile the Spanish state remains on the hook for most of these losses. While ‘in theory’ the Eurozone leaders have agreed to a direct injection of equity capital into troubled Spanish banks, there is very little likelihood of this happening any time before 2014. Also, under the terms as currently understood, any losses that may materialize between now and then would need to be absorbed by the Spanish sovereign. It is also highly unlikely that any ESM equity will be injected into Spain’s bad bank, which as the Irish case illustrates, can inflict significant additional losses. So despite the deal that was announced with much fanfare the fact remains that the link between Spanish banks and the sovereign will not really be broken and that the Spanish sovereign remains on the hook for the vast majority of rising losses that are likely to materialize in Spanish banks.

Given the large stock of real estate assets and loans in the Spanish economy, it would then not be an exaggeration to suggest that the direct and indirect impact of every additional 1% of GDP of austerity could be to increase realized losses in the Spanish banking system by a multiple of that, 2%-4% according to our back of the envelope calculations.

This means that efforts to shrink the fiscal deficit that was close to 9% in 2011 not only shrink the GDP thereby worsening the debt to GDP ratio but will also inflict large additional losses on the Spanish sovereign that may actually end up increasing the fiscal deficit too. Another phenomenon that adds to this is the collapse of profit based business taxation revenues that are very sensitive to growth in the economy and rising unemployment payments. And these are just the first order economic impact, that ignore the problems of hysteresis (i.e. permanent losses in productivity because of path dependence), of social unrest, of the emigration of the most talented and dynamic people.

While Spain undoubtedly has to make big adjustments and will need to tackle the collapse of its real estate bubble head on, a different adjustment path that uses countercyclical fiscal policy and sets up a resolution mechanism for banks would make much more financial, economic, social and political sense. But for this, Spain needs the support of its Eurozone partners.

Sitting as it does, atop the Spanish donkey, it is imperative for the current Spanish government and its Eurozone partners to remove the two weights pulling the economy down 1) austerity and 2) losses in the banking sector. Instead, deep austerity measures, rising unemployment and the mutiplying losses in the banking system serve to increase the weights thereby inflicting mortal wounds on the economy. This way lies economic collapse social unrest and political disaster. EU, please change course!